The “deoffshoring” law1 (the “Law”) was adopted in the second and third readings by the State Duma on 18 November 2014, and approved by the Federation Council on 19 November 2014. There has been only one significant change to the Law by the State Duma in the course of parliamentary discussions: the higher 50% participation threshold for a company to be recognized as a controlled foreign company will disappear one year earlier, i.e., as of 2016. Other changes are of a technical nature: the formulas for calculating the effective tax rate of a CFC and the weighted average Russian profits tax rate were finally presented (please see next page), and incorrect references were eliminated from the text. The Budget and Taxation Committee of the State Duma rejected all of the amendments to the Law submitted by the Russian Government. According to recent comments from the Russian Ministry of Finance, some of these suggestions may be introduced as amendments to the Russian Tax Code during the Spring parliamentary session. Changes that are in favor of the taxpayer, if adopted, may be applied retroactively. It is expected that the Law will be signed by the President shortly to become effective as of 1 January 2015, leaving little time to prepare. Implications for taxpayers The new rules dramatically change the tax planning landscape for Russian residents and are aimed at the taxation of undistributed income held offshore and to encourage the return of a part of the capital back to Russia. The Law introduces a substantial new tax burden on Russian individuals and legal entities that use various international holding, financing, or licensing structures that can be recognized as controlled foreign companies (CFCs). Besides eliminating the Russian tax deferral effect and increasing the tax burden, the new rules would result in significant compliance costs for maintaining foreign structures and increasing their local substance, making notifications and tax filings, calculating and reporting CFC profits, etc. What the law says The Law introduces: (1) a controlled foreign companies (CFC) tax regime, (2) Russian tax residency rules for foreign companies based on an effective management and control test, (3) the beneficial ownership concept, and (4) 1. Draft Law No. 630365-6 “On Amendments to the First and Second Parts of the Russian Tax Code (with Respect to the Taxation of Controlled Foreign Companies and the Income of Foreign Organizations).” www.bakermckenzie.com For further information please contact Alexander Chmelev +7 495 787 27 00 firstname.lastname@example.org Sergei Zhestkov +7 495 787 27 00 email@example.com Maxim Kalinin +7 812 303 90 00 firstname.lastname@example.org Baker & McKenzie — CIS, Limited White Gardens, 10th Floor 9 Lesnaya Street Moscow 125047 Russia Tel.: +7 495 787 27 00 Fax: +7 495 787 27 01 BolloevCenter, 2 Floor 4a Grivtsova Lane St. Petersburg 190000 Russia Tel.: +7 812 303 90 00 Fax: +7 812 325 60 13Tax 2 Legal Alert November 2014 rules on taxation of the indirect sale of Russian real property. A summary of the key provisions of the Law is given below. 1. Taxation of the Income of Controlled Foreign Companies Controlled Foreign Companies A CFC is a foreign company (or unincorporated structure) that is controlled by Russian individuals or legal entities or where they own, directly or indirectly (through other Russian or foreign companies), (1) more than 25% of the shares, or (2) more than 10% if Russian persons in total own more than 50%, subject to the exemptions outlined below. The Law provides for a transition period until 1 January 2016 when a foreign company will be recognized as a CFC if Russian individuals or legal entities own more than 50% of the shares in the company. Controlled foreign “structures” that are not legal entities, e.g., funds and partnerships, that may engage in business activities on behalf of their partners/beneficiaries are also treated as CFCs. The new rules could also cover certain types of trusts and other popular wealth management tools. The major exemptions from CFC status include: Effective tax rate. Companies established in jurisdictions that have concluded tax treaties with Russia and exchange tax information, whose effective tax rate is 3/4 or higher of the weighted average Russian profits tax rate (composed of 20% standard rate and 9% rate for dividends based on the structure of CFC income). Active income companies. Companies established in tax treaty jurisdictions exchanging tax information with no more than 20% of income being passive income. “Passive income” is broadly defined to include dividends, interest, royalties, capital gains, leases, certain services, etc.; Licensed banks, insurance companies (but not their subsidiaries), certain other types of companies. Foreign companies in corporate and private structures may need to be carefully checked to see whether they can rely on any of the exemptions. CFC Income Attributable to Russian Taxpayers Russian taxpayers that are controlling persons are required to report a pro rata share of the CFC income in their tax declarations by the end of the year following the year for which the CFC prepared its financial statement (i.e., the first reporting campaign would be for 2016). CFC income is determined according to audited financial statements if the CFC is subject to mandatory audit under applicable domestic rules (e.g., for Cypriot companies), otherwise the tax base is determined under the Russian tax rules i.e., Chapter 25 (for typical offshores). CFC income is reduced by the amount of interim and annual dividends distributed by a CFC and related to the period of the financial statement. A foreign tax credit for the amount of foreign and Russian taxes paid on the CFC income is available. CFC profit below a minimum threshold (RUB50 million in 2015) is not taxed in Russia. CFC income is subject to ordinary tax rates in Russia: 13% for individuals; 20% for legal entities. Consequently, the accumulation of income in offshore companies may become less efficient compared to regular dividend Effective and Average Russian Profits Tax Formulas The effective and the average Russian profits tax rates are determined according to the following formulas: T — the sum of the amount of tax paid by a foreign company in accordance with its personal law and the amount of tax withheld at the source of the income; P — the sum of income (profits) of the foreign company. P1 — the sum of profits of a foreign company except for dividend income; P2 — the sum of dividend income received by the foreign company; R1 — Russian corporate profits tax base rate (20%); R2 — Russian dividend tax rate (9% in 2014, may be increased to 13% starting from 2015).Tax 3 Legal Alert November 2014 distributions taxed at a lower 9% rate (although there are plans to increase the dividend tax rate to 13%), which needs to be factored into the analysis of existing structures. Tax Incentive for “Bringing” Business to Russia The Law grants a special tax exemption allowing the liquidation of CFCs free from taxes in Russia. Income received by Russian companies on liquidation of a CFC is tax exempt until 1 January 2017. There are special rules on accounting for assets received in such CFC liquidations. There are no corresponding tax exemptions for Russian individuals. Notification on Participation in Foreign Companies Russian taxpayers are required to file separate notifications with the Russian tax authorities on (1) owning more than 10% of the shares in foreign companies and (2) participation in CFCs: Notification on owning shares in foreign companies: must be filed within one month of the acquisition date or by 1 April 2015 for existing shareholdings. Notification on participation in CFCs: due by 20 March of the year following the year for which the CFC's income is included in the tax base of the controlling person (i.e., the first notification will be due by 20 March 2017). Liability for Non-Compliance The Law provides an exemption from tax penalties arising in connection with tax underpayments on CFC income for 2015–2017. There is an exemption from criminal liability for 2015–2017 provided all tax amounts (including tax assessed and late payment interest) are paid to the budget. Failure to file a notification on owning shares in foreign companies or a notification on participation in CFCs is subject to penalties of RUB50,000 and RUB100,000, respectively, for each company. 2. Russian Tax Residency of Foreign Companies Foreign companies may be deemed Russian tax residents (subject to taxation in Russia on worldwide income) if any one of the following criteria is met: (1) the majority of the board of directors (or similar body) meetings in a calendar year take place in Russia; (2) regular effective management of the day-to-day activities under the competence of the executive bodies is performed in Russia, or (3) the key managers take decisions in Russia. In addition, the following secondary criteria are introduced: (1) accounting and management accounting is performed in Russia, (2) document (records) management is performed in Russia, or (3) operational HR management is performed in Russia. There is an exemption for companies with commercial activities carried out by local qualified personal and using assets in a state which has a tax treaty with Russia, which is intended to focus the attention of the Russian tax authorities on aggressive use of “paper” offshore companies. The adoption of these rules may create significant risks for foreign companies that do not have solid local substance e.g., an actual office or functioning Tax 4 Legal Alert November 2014 decision-making bodies in the state of their registration, and where they are actually managed by beneficiaries from Russia. 3. Beneficial Ownership Concept The Law introduces the concept of a beneficial owner, which seems to be more onerous than the accepted OECD interpretation. Withholding tax exemptions or reduced tax rates under tax treaties concluded with Russia are only available to beneficial owners of income (exercising functions and risks with respect to such income and determining its “economic fate”) and should not be provided to foreign companies having limited authority to dispose of income and exercising intermediary functions. Russian tax agents received a right to obtain confirmations of the beneficial owner status from recipients. This is likely to result in more uncertainty and tax risks for many cross-border payments. 4. Taxation of Indirect Sale of Russian Real Property The current version of the Russian Tax Code treats capital gains on the sale of shares in a Russian company by a foreign company without a Russian permanent establishment as being Russian source if more than 50% of the assets of the Russian company are real property located in Russia. The Law extends this rule to include capital gains on the sale of shares in a company (either Russian or foreign) if it has assets directly or indirectly consisting of real property in Russia. The Law introduces a new requirement for foreign companies (and unincorporated “structures”) holding real property in Russia to disclose direct and indirect owners (full ownership chain including individual beneficiaries) along with filing property tax returns. Actions to consider The new rules call for immediate attention and action for most international structures of Russian individuals and companies as the Law is likely to be passed in an expedited process and will apply as of 1 January 2015 leaving little time to prepare. In preparation for the new rules, the following actions may be suggested: review the existing group structure and effective tax rates in relevant jurisdictions to identify all foreign companies/structures that may be caught by the CFC rules; analyze potential restructuring opportunities to maintain efficiency under the CFC rules, including reorganization, streamlining of dividends prior to 2015, and eliminating redundant foreign companies. The optimal modifications need to be carefully tailored depending on the existing structures; optimize new reporting obligations and consider the financing and cash-flow structure to finance additional tax liabilities in Russia (e.g., taxes on CFC profits); identify foreign companies that may have insufficient substance and may be recognized as Russian tax residents. Redesign internal management processes to avoid Russian tax risks; identify the beneficial ownership risks in the existing holding, financing and licensing structures and consider protective measures or restructuring;Tax 5 Legal Alert November 2014 review real property holding structures and consider modifications on exit (sale) strategies in light of the new Russian withholding tax rules. We will continue to provide timely information on expected amendments to Russian tax legislation. This LEGAL ALERT is issued to inform Baker & McKenzie clients and other interested parties of legal developments that may affect or otherwise be of interest to them. The comments above do not constitute legal or other advice and should not be regarded as a substitute for specific advice in individual cases.